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Get Ready for the Fall

The bigger they are, the harder they (might) fall.

"The bigger they are, the harder they fall." It's the worst nightmare of every investor in today's market -- buying a rocket stock just before it takes a nosedive.

Every day, WSJ.com publishes a list of stocks whose shares have just hit new 52-week highs. Every day, investors read the list and tremble -- some with greed, others with terror. Within our Motley Fool CAPS investing community, these top stocks generally enjoy favorable ratings, since everyone loves a winner ... but not always:

Companies are selected from the "New Highs & Lows" lists published on WSJ.com on Friday last week. 52-week low and recent price provided by Yahoo! Finance. CAPS ratings from Motley Fool CAPS.

A sigh of relief... and then a roarAs fears of a Greek debt meltdown continue to fade, traders have released their white-with-fear grip on their Bloomberg terminals, markets given a sigh of relief -- and stocks turned cautiously green again. The S&P 500 has now strung together five "positive" weeks in a row, and some of the biggest names in stock-picking are once again hitting 52-week highs.

But can they hold onto (and add to) these gains? Opinions are mixed. CAPS members appear to think JDS, FedEx, and IMAX are priced fairly relative to future prospects, but worry that Comcast has gotten a little ahead of itself. Fortunately, there's one stock on today's list about which Fools have no doubt:

"Everybody?" Yes, everybody. You, me, the local water utility ... and oil majors like BP(NYSE: BP) and ConocoPhillips(NYSE: COP). Because as mtinvest informs us, Flowserve doesn't just make "pumps and valves" for water companies. They also "sell subsea flow control systems to the oil and gas industry. In terms of revenue from fluid control systems Flowserve is second only to ITT corporation."

And that's not all. In fact, far from it. mookimd opens up a whole slew of arguments in favor of Flowserve, beginning with the fact that it's: "Diversified across many different industries with different product lines." It's also: "Spending increasing amounts to develop in emerging markets, and especially China." Furthermore: "Demand will start to expand or already are expanding once economy turns around." And of course, the company also boasts a: "Solid track record of organic growth" and that "Servicing, repairs, and replacement on already sold products account for 75% of sales."

Good news and bad newsBut that's just the problem. On the one hand, mookimd is right that drawing such a high proportion of its revenue from recurring sales provides a "steady revenue stream" to Flowserve. This lends itself to stability in the business and suggests predictable returns for investors.

On the other hand ... mookimd is right. This steady revenue stream makes it easy for us (and for Wall Street) to predict how Flowserve will perform in the future. Unfortunately, it also means that when analysts tell us that Flowserve is only going to grow at about 2% per year for the next half-decade, they're probably right about that. And to my Foolish eye, 2% earnings growth just isn't enough to justify buying a 15 P/E stock.

It's especially unattractive in light of the fact that Flowserve doesn't even make as much money as its GAAP earnings suggest. Free cash flow for the past 12 months comes to only $323 million, or just 75% of what the company reports as "net profit" under GAAP. When applied to the firm's $6.3 billion market cap, it also pushes the company's price-to-free cash flow ratio up near 20 -- again, on a 2% growth stock.

Foolish takeawayWhen you consider further that Flowserve's free cash flow production today exceeds the average amount of cash it's produced annually over the past five years by nearly 50%, the prospects for continued outperformance here look all the bleaker. Such outsized gains simply aren't likely to be sustained over the long term, and as soon as investors discover this sad fact -- that, Fools, is when this stock will fall.

Of course, that's just one Fool's opinion, and not every-Fool agrees with me (to the contrary, The Motley Fool itself owns shares of Flowserve.) So if you hold a contrary opinion, there's no reason to be shy about expressing it. Pull up a soapbox, and tell me why I'm wrong.

Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 775 out of more than 160,000 members. The Fool has a disclosure policy.

Author

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.